Expected utility / financial utility

How an investor perceive 
the expected risk and payoff


Expected utility / financial utility measures an investor perception
of what an asset or a deal is worth for her/him.

It takes into account
* her/his anticipated risk and payoff,
* and its own attitude towards risk taking.

It can differ - slightly or largely - from the market price.

sous What it is worth for you might be different
from what it is worth on the marketmarket.

A form of value

Expected utility, in other word what value we attribute to a monetary
operation
by appreciating its possible outcomes, is a specific form of

economic utility applied to finance.

Expected utility, if we stick to the financial meaning, is ...a number.
It is what a deal, a project or an asset is considered worth
in monetary terms
for an individual investor (and by extension
to a collective one).
  • This supposes the person (*) does a mental projection,
a mental time travel to the future state of affairs,  so as to
evaluate what
wealth gains vs. poor risks / losses
the asset (or a financial move /deal) can bring.


=> Whence the term "expected" applied to utility.

(*)
or organization in the case of collective utility))
  • Intervene also the person or organization's risk risk attitude.
It is either a risk aversion or (less usually) a risk seeking).
It can lead
* not only to  over- or under-estimate the risks when doing
   the above cited evaluation (distorted risk perception),
* but also to deliberately add or deduct a personal (or collective)
   risk premium
to that valuation.

Such  a valuation gives therefore a personal / institutional value,
which entails at the same time objective reasoning and personal /
collective feelings in the form of conscious or unconscious expectations.

=> This estimate can differ - slightly or largely  - from
      the market price.


See details in the main
article:
Value - utility - price
More precisions on the mathematical
"parameters" and their limitations

That personal expected value for the owner / investor takes into account
three main elements:
  • His/her perception of the assets' fundamentals
  • His/her own vision of its prospects (probable risks and payoff)
  • His/her risk attitude (appetite or aversion).
Expected utility supposes a calcul present value calculation
based on known or supposed probabilities.


But things are often not so clear cut,
a thing that should be taken into account by deciders:
=> Risk is something measurable by probabilities which are
         not
fully relevant as the future is actually the world
       of  fog
uncertainty.

=> We shall nor forget the "human factor"

       
(see
behavioral economics).

=> Nor the strange paradox of the utility vs. disutility
       
asymmetry  (something related to loss aversion, which
        is not the same notion than risk
aversion according to the
       
prospect theory).

=> And various other utility paradoxes found by researchers.
See details and calculations in the main articles:
Asset valuation and Stock valuation

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M.a.j. / updated : 08 July. 2015
All my ex-knols / Tous mes ex knols
 

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